Every investor knows that market volatility is a part of life. Investors will also know that if their portfolio drops by 50%, they need a 100% increase on what’s remaining just to get back to square one! Yes, investors understand Volatility.
But Volatility is much more than just shares going up and down. All financial instruments contain degrees of volatility and this in turn affects investors in varying ways.
In this edition of Investor Insights, we take a look at volatility, risk and alternatives investors may like to consider.
Markets price for foreseeable events. Impending rate cuts, likely currency values, political results and economic indicators are analysed ad infinitum and any likely volatility taken into account in prices. Unforseen or irrational events create the greatest level of volatility. ‘Unknown Unknowns’, as Donald Rumsfeld may have put it.
‘Unknown-unknowns’ include political unrest, global economic events, weather events, war – the list goes on. These shocks can create global volatility and present the investor with more than a mere headache.
A quick look at the below chart covering the All Ordinaries over the last 33 years shows that the biggest movements in the index are from events which are difficult – or even impossible – to predict.
Measurements of financial volatility.
Volatility, simply put, is the variance of returns expected for a particular asset or market index. There are numerous ways of measuring volatility with varying degrees of complexity. Most begin with assessing the historical volatility of a particular stock or index and then use that information to look forward into the future. A common approach is to measure returns against the likely returns of the market on the whole, or, the Beta coefficient.
Friend or Foe?
For the right investor, volatility can be a friend. Assets with higher perceived volatility will usually offer a higher return and the canny investor can do very well. An investor’s risk profile is important here.
There are some cases where volatility is no friend at all.
Investing for income & the hunt for yield
If you rely on investments to generate your income, volatility is something you can do without. Much has been written about the ‘Hunt for Yield’. In the current low-rate environment with many capital stable investments barely out of negative real return territory, investors are increasingly turning to ‘riskier’ assets to generate income.
An example of this exists in SMSF asset allocation, with the following table demonstrating the move away from cash and into shares since 2008:
||31 Dec 2008
||31 Dec 2014
There is a concern that investors are abandoning risk profiles for the sake of income and increasing their exposure to undue risks. We all need to eat, but one wonders if the full array of products available for constructing a properly diversified portfolio are being considered.
Transitioning to retirement – Sequencing Risk
All of us at some time will be looking forward to retirement. In the years where retirement is becoming imminent, volatility brings about ‘Sequencing Risk’, or, the risk that the timing of losses is unfavourable and results in less money for retirement. This is particularly pertinent for Australian investors, as 76.1% of singles and 41.9% of couples run out of savings in retirement (Burnett, Davis, Murawksi, Wilkins & Wilkinson, 2013).
Referring back to the ASX chart (above), if an investor held shares representing the ASX in 2007, by 2008 their portfolio would have decreased in value by 50%. What’s more, fast forward to 2015 and they would still be behind where they were in 2007! This can be catastrophic for those nearing retirement who do not have the luxury of time to make up losses.
Reliable, low-volatility returns are very attractive to these investors to ensure their portfolios maintain their value as they near retirement.
Most financial strategists agree that volatility is best addressed using diversification – selecting the right product mix to ensure the aims of the investor are achieved and the risk profile is being addressed. The following product types are typical fixed-income alternatives many investors will consider.
ETPs or Exchange Traded Funds (ETFs) are an increasingly popular means of building simple diversification. These products invest in a selection of assets to mimic the returns offered by a particular index or benchmark and in doing so investors gain comfort in the assumption that any losses they experience will not be out of synch with any wider market move.
Bonds of varying types have long held a position in most investor’s portfolios. However, with interest rates likely to be upwards from here care needs to be taken to ensure the market value of the bonds selected do not devalue in the years ahead.
These are relative new comers in the context of financial instrument history, increasing in popularity only in the past ten years. Each hybrid issuance is subject to its own terms and conditions, so requires full investigation each time especially regarding conversion events.
Term deposits offer a low-volatile option for investors and have long been the prime product in fixed interest investment. Add the Government Bank Guarantee for investments up to $250,000 and from a volatility perspective there is very little to worry about. However the current low rates on offer are a serious detraction for investors as they are often behind the rate of inflation and therefore investors can see the real value of their investments decreasing over time in this current environment.
La Trobe Financial – low volatility investing
The flagship product of La Trobe Financial is our Pooled Mortgages Option (PMO), which is currently returning a variable 5.40% per annum with monthly income distributions. The PMO is designed to take advantage of the outstanding risk/return characteristics of the Australian property credit market, with an investment strategy based on conservatism.
With its high level of capital stability and a strong premium to cash the PMO offers, monthly income for investors with low volatility. Whilst past performance is no guarantee of future performance, as the graph below demonstrates, the PMO has delivered returns with exceptionally low absolute return volatility since inception in 2002. Importantly, its performance profile has notably low correlation to other asset classes and has acted to stabilise portfolio performance both in market peaks and in market troughs.
Every investor will be affected by volatility in some way through their investment lifetime. Addressing the risks volatility creates should be a key consideration of the considered investor. As always, creating a clearly articulated financial plan which addresses these risks, which is regularly reviewed and is backed up with thorough asset allocation should place you in good stead.